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Mitigating Estimation Risk in Asset Allocation: Diagonal Models Versus 1/N Diversification

31 Pages Posted: 15 Jul 2016  

Chris T. Stivers

University of Louisville

Licheng Sun

Old Dominion University

Multiple version iconThere are 2 versions of this paper

Date Written: August 2016

Abstract

Recent literature suggests that optimal asset‐allocation models struggle to consistently outperform the 1/N naïve diversification strategy, which highlights estimation‐risk concerns. We propose a dichotomous classification of asset‐allocation models based on which elements of the inverse covariance matrix that a model uses: diagonal only versus full matrix. We argue that parsimonious diagonal‐only strategies, which use limited information such as volatility or idiosyncratic volatility, are likely to offer a good tradeoff between incorporating limited information while mitigating estimation risk. Evaluating five sets of portfolios over 1926–2012, we find that 1/N is generally not optimal when compared with these diagonal strategies.

Keywords: portfolio optimization, naïve diversification, idiosyncratic volatility

JEL Classification: C13, C51, G11, G12

Suggested Citation

Stivers, Chris T. and Sun, Licheng, Mitigating Estimation Risk in Asset Allocation: Diagonal Models Versus 1/N Diversification (August 2016). Financial Review, Vol. 51, Issue 3, pp. 403-433, 2016. Available at SSRN: https://ssrn.com/abstract=2809970 or http://dx.doi.org/10.1111/fire.12108

Chris T. Stivers (Contact Author)

University of Louisville ( email )

Finance Dept., College of Business
University of Louisville
Louisville, KY 40292
United States
502-852-4829 (Phone)

Licheng Sun

Old Dominion University ( email )

Strome College of Business
Department of Finance
Norfolk, VA 23529-0222
United States

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